Short Initial Plan Year Cash Balance/401(k) Combo

Defined contribution guy here hoping for some clarity from a cash balance expert or two. A small business owner with 5 employees has decided to start a 401(k)/cash balance combo in 2020.  The 401(k) is safe harbor and he got it in just under the deadline - the plan effective date was 10/1/2020, however the limitation year and the compensation computation period are both set to calendar year so we can include full 2020 compensation and limits.

We have proposed to do the exact same with the cash balance plan - 10/1/2020 plan effective date with the limitation year and compensation computation period set to calendar year. It is my understanding that the plan years must be identical for the plans to be aggregated for testing so we would have to use 10/1/2020 for the cash balance plan effective date. The actuary I am working with is telling me the benefits would have to be reduced by about 75% of what was originally projected for 2020 because of the short plan year. The cash balance plan document is from the same provider as my 401(k) document and the language regarding the limitation year and the compensation computation period are consistent in both.

I trust the opinion of my actuary but I am having a hard time accepting this. Does 401(a)(17) force a cash balance plan to prorate compensation in a short initial plan year even if the plan document permits us to use the full calendar year compensation?  I don't see that it does (although I could be wrong) so is there something else that forces proration of compensation or contribution limits?

I'm curious, I rarely see small 401(k) plans with compensation as the calendar year, though many pre-approved plans do allow the option. I think for it to work the way you suggest, it would need to be very clear, such as plan compensation being defined as compensation in the 'calendar year ending in the plan year' , which would make the compensation period disregard the short plan year. Is that really how the document is written?

More typically, I see plans use the default, plan year, which for a short plan year, does get limited to ACTUAL compensation earned during the short plan year. The compensation limits being prorated is a separated issue. 

To avoid the issue you've encountered, we often draft new plans with special deferral and safe harbor start date of 10/1, but the plan effective date is still 1/1. This makes is clear that is the employer wants to give a discretionary employer contribution ( or add a DB plan), the plan year is the full calendar year.  There are some compelling reasons to have a short plan year from 10/1 -12/31 for an initial plan year, but I don't see them often. 

Which document provider do you use? Or are you willing to share the language from the 401(k) plan?

Also - I suppose they could adopt a PS only plan effective 1/1/2020, would that make the actuary feel better when combined the PS, 401(k)/ SH, and CB benefits for testing? 

Short background - I had a mentor (CPC, QPA... the whole alphabet soup of designations) many moons ago who didn't like to have the plan effective date be earlier than the date the documents were signed. In a plan where it was important to use the full year of compensation and the full year of contribution limits in the initial short plan year, she would set the limitation year and compensation computation period to calendar year. I have held onto that method of dealing with this situation but maybe it is time for this old dog to change.

We use ftWilliam for 401(k) and cash balance plan documents. I have asked them specifically if this method was acceptable and they said it was. The specific sections of the 401(k) adoption agreement (cash balance AA is set-up the same) read as follows:

Compensation is determined over the period specified below ending with or within the Plan Year:
i. [ ] Plan Year
ii. [ X ] calendar year
iii. [ ] Plan Sponsor Fiscal Year
iv. [ ] Limitation Year
v. [ ] Other twelve-month period beginning on: (enter month and day)

Plan Year
a. [  ] Plan Year means each 12-consecutive month period ending on 12/31 (e.g. December 31)
b. [ X ] The Plan has a short Plan Year. The short Plan Year begins 10/01/2020 and ends 12/31/2020

Limitation Year means:
a. [  ] Plan Year
b. [ X ] calendar year
c. [ ] tax year of the Plan Sponsor
d. [ ] other:

If my mentor was wrong - and by extension I am wrong - I am happy to change my ways. I haven't had anyone tell me I'm wrong about this. My actuary hasn't even said I'm wrong - just that they won't do it this way but they won't provide any concrete evidence as to why. I appreciate any opinions one way or the other.

On 12/11/2020 at 7:43 PM, justanotheradmin said:

To avoid the issue you've encountered, we often draft new plans with special deferral and safe harbor start date of 10/1, but the plan effective date is still 1/1. This makes is clear that is the employer wants to give a discretionary employer contribution ( or add a DB plan), the plan year is the full calendar year.  There are some compelling reasons to have a short plan year from 10/1 -12/31 for an initial plan year, but I don't see them often. 

I agree with "the other admin".  I see no reason to do a short plan year - it just complicates the process.

However, to answer your initial question, yes, having a short plan year can significantly reduce the amount of the DB contribution in year one.  I would argue needlessly, because as the other amin said, "there is generally no compelling reason to have a short plan year".